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The important role of sukuk in the Basel III era

Author: Dr. Sutan Emir Hidayat

Director of the MBA Program, University College of Bahrain

Source: Thomson Reuters Sukuk Perception & Forecast

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The implementation of Basel III rules has created several challenges to Islamic financial

institutions (IFIs) especially with regards to capital adequacy and liquidity requirements.

Basel III primarily requires all banks, including Islamic banks, to strengthen their capital and

liquidity positions by holding higher quality capital, which would enable banks to absorb

financial shocks, and maintain higher level of liquidity, which enables banks to reduce their

dependency on money market instruments.

Basel III requires all banks to maintain the minimum ratio of 4.5% for tier 1 common equity

capital, an increase from 2% required by Basel II. Basel III also changed the minimum

requirement for additional tier 1 capital and tier 2 capital to 1.5% and 2%, respectively, from

2% and 4% previously required by Basel II. In addition, Basel III requires banks to maintain

2.5% capital preservation buffer and 0-2.5% countercyclical capital buffer.

In addition, Basel III also redefines the meaning of capital. According to Basel III, the

components of tier 1 capital consist of common equity as core capital, and preferred stock

and hybrid securities as additional capital. Subordinated bonds and loans are counted as tier 2

capital.

Given the uniqueness of Islamic banks' products and operations, the implementation of Basel

III rules for Islamic banks and other IFIs requires more clarification. The Islamic Financial

Services Board (IFSB) released IFSB-15 in December 2013 with the purpose of introducing a

framework for capital adequacy and liquidity requirements to suit the uniqueness of IFIs.

IFSB-15

The IFSB-15 is an amended and improved version of two previous IFSB standards on capital

adequacy, namely IFSB-2 and IFSB-7. IFSB-2 focused on capital adequacy standards for IFIs

while IFSB-7 focused on capital adequacy requirements for sukūk, securitizations and real

estate investments. IFSB-15 also provides guidelines for the components of regulatory capital

(tier 1 and tier 2). Like Basel III, IFSB-15 also defines common equity as the tier 1 core

capital and preferred stock as the additional tier 1 capital. However, it is important to note

that preferred stock is only considered a Shariah-compliant instrument in some jurisdictions

such as Malaysia.

In addition, perpetual musharakah sukuk is also counted as additional tier 1 capital, while

mudharabah and wakalah sukuk with maturity of five years or more are counted by IFSB-15

as components of IFIs’ tier 2 capital. However, in practice, other types of sukuk may also be

classified as either additional tier 1 or the component of tier 2 capital as long as the sukuk

fulfill IFSB-15 requirements for each category of capital. In summary, the IFSB-15 has

stressed the important role of sukuk in the Basel III era.

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Basel III-compliant sukuk

From the above explanation, it is clear that the implementation of Basel III and IFSB-15 has

opened the way for sukuk to be used by Islamic banks and other IFIs as the alternative

instrument to comply with regulatory requirements. Certainly, the adoption of Basel III will

boost the number of sukuk issuance and their transactions value.

Basel III has already created a new trend in the sukuk market with the birth of so-called

"Basel III-compliant sukuk". There have been nine issuances of such instruments since Basel

III's initial implementation which kicked off in January 2013 with total deals worth more than

USD 4.93 billion, according to Annuar (2014).

The first issuance of Basel III-compliant sukuk came from Abu Dhabi Islamic Bank (ADIB)

in November 2012, even before the initial implementation of the accord. ADIB issued

perpetual mudharabah sukuk with the purpose of raising its additional tier 1 capital.

Following ADIB’s success, Dubai Islamic Bank (DIB) issued the second Basel III-compliant

sukuk in March 2013 for the same purpose. At the end of 2013 and at the beginning of 2014,

three issuances of such sukuk occurred in Saudi Arabia, from Saudi Hollandi Bank (SHB),

Saudi British Bank (SAAB) and National Commercial Bank (NCB). Unlike the Emirati

banks, the Saudi banks issued the sukuk to increase their tier 2 capitals.

The successful experience in the GCC has been followed by Islamic banks in Southeast Asia

especially in Malaysia with the issuances of Basel III-compliant sukuk by AmIslamic Bank,

Maybank Islamic, RHB Islamic and Public Islamic (using the murabahah structure) which

aim to boost the banks' tier 2 capital. Many more issuances of such sukuk are expected in the

years to come.

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Forecast 2015 on www.Zawya.com and continue reading to view the role of Sukuk for

liquidity management.